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19 Jan 2016

How the Current Interest Rate Adjustment Differs from the Previous Rate Hike Cycle

Seventy-eight months after the great recession ended, the Fed at last decided to end its zero interest rate policy. By raising the Fed funds rate from 0 – 0.25% to 0.25% – 0.5%, the Fed initiated interest rate normalization. In spite of the first rate hike in nearly ten years, monetary policy will remain accommodative for an extended period of time, and the so-called tightening cycle may not even materialize. The last rate hike dated back to 2006. It was a different world where the first smartphone had yet to be marketed, Greek and German bonds yielded more or less the same, and the Hong Kong dollar was worth more than the RMB. Under the linked exchange rate system, Hong Kong’s interest rate environment largely hinges on the Fed’s monetary policy. Nevertheless, the dynamics of the current interest rate adjustment differs from the previous rate hike cycle in many aspects.

I. The current rate hike cycle likely to be short-lived

From December 2000 to July 2003, then Fed Chair Greenspan lowered the Fed funds rate from 6.5% to 1%, a then record low. From July 2004, the Fed funds rate began to rise in 25 basis-point increments and reached 5.25% in July 2006 after a total of 17 hikes.

The last trough-to-peak transition in terms of the tightness of monetary policy took place during the three-year period between mid-2003 and mid-2006. Back then, annual GDP growth averaged 3.5%, far outpacing the 2.1% clip recorded in the current anemic recovery. Fed tightening also started a lot sooner, with the first rate hike taking place in the 32 nd month of expansion. By contrast, in the current cycle, benchmark interest rates remained unchanged until the 78 th month of recovery. Weak growth momentum coupled with six and a half years of zero percent interest rate policy suggests that the Fed may have already missed its rate-hike window.

Due to the following three reasons, frequent and regular rate hikes are extremely unlikely to be repeated.

1. Weakening growth momentum

The U.S. economy began to recover in June 2009, and its prolonged expansion may be nearing an end. Total manufacturing sales have been contracting ever since January 2015, while the persistent decline in new factory orders started even earlier in November 2014. Moreover, the inventory to sales ratios continued to trend upwards, which is an extremely rare phenomenon in an expansion. Rising inventories imply that demand has been consistently overestimated. Eventually, destocking will substantially subtract from growth.

Manufacturing is only a small part of the U.S. economy, but sustained weakness in the relatively volatile sector could be a precursor to an overall recession. Many services industries, such as logistics, transportation, and warehousing, depend on the health of manufacturing. And make no mistake; U.S. manufacturing is already in recession. The ISM manufacturing index dropped below the 50 threshold to 48.6 in November and declined further to 48.2 in December. These were the worst readings since the end of the great recession in June 2009. Even if a full-blown recession is not yet imminent, a turning point may have been reached. Barring an unlikely rise in inflation, the cumulative magnitude of interest rate increases will be very limited. The much-touted rate hike cycle could turn out to be premature.

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